Expense deductions are CRA's business

Salaried employees sometimes envy business owners for their ability to deduct certain expenses, like entertainment of customers, travel to conferences and automobile expenses. (Less enviable are things like 18-hour days, financial stress and human-resource issues, but we'll leave that for another day.)

If certain conditions are met, salaried employees can start a business and deduct legitimate business expenses, even if those deductions result in a net loss for the business. If the business is set up as a proprietorship rather than a corporation, then the employee may be able to deduct those business losses on the personal tax return. (For discussion on whether or not to incorporate, go to my website.)

That's the carrot; here's the stick. Claiming business expenses puts you in a higher risk category for an audit by the Canada Revenue Agency (CRA), and those expenses will be rejected unless a number of conditions are met. This is true whether or not the business is incorporated.

For expenses to be deductible, there has to be a business -- a commercial activity.

The Supreme Court in 2002 (Stewart case -- 2002 SCC 46) outlined the test. First, is the activity undertaken in pursuit of profit, or is it primarily a personal endeavour?

Second, is the source of income a business or property?

The answers are often black and white. For example, when a person creates a business plan showing the expectation of profit in two years (let's say), signs a lease to rent space, hires employees, purchases inventory and advertises, it's fairly clear that money was invested to earn profit, and a business will be a source of income.

The Supreme Court was clear that a commercial endeavour, with no personal element, will be able to deduct its expenses, whether showing a profit every year or not, as long as a source of income exists.

Even in that situation, all income and expenses must be thoroughly documented, and you must have detailed receipts to support any expenses. Tracking is simplified by putting all income and expenses through one business bank account and using a credit card that is exclusively for business.

However, note that credit card and bank statements alone are not valid proof of the expense, just proof of payment. You really need a third-party receipt. For example, if the expense is a restaurant meal, you will need both the itemized statement of the food and beverages purchased and the credit card slip or receipt as proof of payment. (And only half of an entertainment expense is deductible.)

Certain expenses are never deductible, even by legitimate businesses. As well, expenses in the allowable category are only deductible if that expense was incurred for the purpose of earning income.

What if there is also a personal element?

Let's look at some of the greyer areas, and some pitfalls to avoid. When a person starts a home-based business on a part-time basis while still on salary, that person should be careful about expense deductions and claims. If the business loses money in the first couple of years, and then turns a profit, there's likely no problem establishing the legitimacy of the business. Profit is one form of proof.

This is great, as then expenses like computer, auto, office supplies, reasonable and legitimate entertainment, perhaps travel (up to two industry conventions a year) and other expenses can be deducted. If this creates a loss overall, then this is a reduction in personal taxable income and personal taxes (as long as the business is not incorporated).

Once the business turns a profit, then business-use-of-home expenses may also be deductible, if that area of the home is used exclusively for the business.

The greyer areas are when business items are used for both personal use and business use. A Manitoban lost a court case with CRA in 2011, and had three years of previous large losses denied, when RAand the Tax Court both ruled there was not sufficient "commerciality" in the business. In this case (2011 TCC 484), heavy equipment was used more for personal landscaping and snow removal than for customers, without showing the other characteristics of a business trying to earn a profit.

The court can look at many factors -- business plan showing profit potential, training and experience of proprietor or employees, profit and loss history (if one exists), licensing, and the actual activities carried out, like searching for customers and achieving financial success.

If your business has no real expectation of turning a profit, and your business activities are not really focused on that goal, then expect to have a problem with CRA.

David Christianson is a fee-for-service financial planner with Wellington West Total Wealth Management Inc., a portfolio manager (restricted).

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